City workers pass the Bank of England, centre, in London. Photographer: Chris Ratcliffe/Bloomberg
(Bloomberg) — UK markets suffered a fresh selloff on Tuesday, with the yield on long-dated bonds hitting the highest since 1998 and the pound tumbling, as pressure mounted on Prime Minister Keir Starmer to win the confidence of investors in the government’s budget.
The nation’s assets have become increasingly prone to bouts of weakness as the UK’s precarious fiscal position and stubbornly high inflation make it a target. The problem for Chancellor of the Exchequer Rachel Reeves is that each rout pushes up the debt costs and worsens the fiscal backdrop even more, leaving the economy at risk of ever-higher borrowing costs.
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Reeves is due to deliver a budget before the end of the year, and the chancellor is scrambling to find savings or raise taxes to plug what Bloomberg Economics estimates is a £35 billion ($47 billion) budget hole without depressing economic growth. That may prove politically difficult, given the government had to U-turn on welfare reforms after a rebellion among lawmakers.
“The situation in the UK is quite dangerous at the moment because of the return of the bond vigilantes,” said Ludovic Subran, Allianz chief investment officer. “What is striking is that it took so long to factor in the return of inflation into gilts. Forward guidance on the fiscal side will be needed.”
Yields on 30-year gilts jumped eight basis points to 5.72% on Tuesday and the pound weakened as much as 1.5% against the dollar, the biggest drop since April as the currency lagged its major peers. The FTSE 100 Index retreated 0.6% and an index of domestic stocks fell 2%.
While record demand for a sale of 10-year government bonds appeared to buck the trend, the debt was sold at a discount to the secondary market, which made the high yields hard for investors to resist. The UK’s benchmark 10-year yield is the highest among Group-of-Seven nations, trading up six basis points at 4.81% on Tuesday — the highest levels since January.
The fact that the slump focused on the 30-year bond in particular reflects waning demand for longer debt from traditional buyers such as defined-benefit pension funds, as well as concerns over structurally higher inflation. The UK’s Debt Management Office has already slashed sales of such securities to a record low, and some are calling for it to go even further.
Why UK Inflation Is So High and Tough to Bring Down: QuickTake
WATCH: The UK is in a “dangerous” situation, Allianz CIO Ludovic Subran says.Source: Bloomberg
Tax Test
Economists are predicting the UK will soon need to raise taxes to keep on the right side of the government’s self-imposed fiscal rules. Borrowing costs are a key determinant of the UK’s fiscal arithmetic — potentially putting Reeves and Starmer at the mercy of bond yields.
Explainer: UK Tax Hikes Loom as Reeves Faces Budget Dilemma
Starmer announced a raft of changes to his Downing Street team on Monday in a reset aimed at securing more influence over economic policy. The main fiscal rule is that day-to-day government spending should be covered by tax revenues within five years, so that borrowing is only for investment.
“The moves Starmer made yesterday — bringing some different people into Number 10 — is kind of making people question who’s actually in charge of the fiscal side,” David Zahn, head of European fixed income at the firm, said in a Bloomberg TV interview. He repeated his call for the 30-year yield to surpass 6%.
WATCH: Franklin Templeton’s David Zahn expects the yield on 30-year UK bonds to climb above 6% by the end of the year.Source: Bloomberg
“I think they’re going to continue to try and just plug along and not really address the problems,” Zahn said. “But if the yields get too high, eventually they will have to do something much more substantial which will include spending cuts.”
Starmer’s spokesman, Dave Pares, declined to comment on “specific market movements” when asked on Tuesday, while stressing that “our ironclad commitment to our robust fiscal rules remains.”
Pound Drop
The pound also came under pressure as gilt trading opened. Betting in the options market points to the bleakest month-ahead outlook for sterling since July against the dollar.
“The moves reflect a broad concern about the fiscal outlook in the developed world,” said Valentin Marinov, head of G10 FX strategy at Credit Agricole. “The pound is once again seen as the pressure valve for wary investors.”
The rise in borrowing costs has invited comparisons to the market meltdown under former Prime Minister Liz Truss.
The UK risks a “Starmer Moment” similar to the fallout from Truss’s mini-budget three years ago if the government fails to restore faith in the nation’s public finances, Eurizon SLJ Capital chief executive Stephen Jen and Joana Freire wrote on Friday.
What Bloomberg Strategists Say…
“It is likely that long-dated gilts will continue to be in the spotlight through the autumn budget. If today’s reaction in the pound is anything to go by, traders seem anxious to work in a bigger risk premium into UK assets.
That isn’t good news for sterling, which — having already slipped below its 50- and 100-day moving averages”
—Ven Ram, Macro Strategist. Click here to read the full analysis.
To be sure, the current sell-off is very different in nature.
The 2022 rout saw forced selling that drove the 30-year yield up as much as 50 basis points in one session, compared with a gradual grind upwards in recent weeks.
While the moves aren’t limited to UK bonds, they have been at the epicenter of the global slide in long-maturity debt.
The rate on 30-year gilts has risen more than 100 basis points over the last 12 months, compared with around 80 basis points for comparable US Treasuries and German bonds.
“Tax rises are inevitable, but we are reaching a stage where further tax rises could become counterproductive,” said Mohit Kumar, chief European strategist at Jefferies International. “We remain negative on the UK long end and continue to favour steepeners along the curve.”
–With assistance from James Hirai, Naomi Tajitsu, Vassilis Karamanis, Tom Rees and Alex Morales.
(Updates prices, adds details on bond syndication.)
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